What to know ahead of going IPO? Tax implications of your employer stock options and RSUs.

IPOs are back! From Dropbox to StitchFix and rumors of upcoming debuts for Pinterest and Uber. And that’s great news for many of our clients who have been eagerly awaiting a liquidity event to finally have a chance to sell some of their stock options or RSUs.

And with the spike in IPO activity, we’ve seen a similar spike in the number of questions coming to our Visor tax advisors. So we thought we’d utilize this article to share the key things to know in advance of your employer’s IPO.

The main takeaway: the earlier you get started on your planning, the more advantageous it will be. So get in contact with a Visor tax advisor today if your company has begun the process of publicly listing its shares.

What’s the typical timeline?

This isn’t a pure tax question, but timing is super important for tax due to different rates that apply based on the holding period of your stock or options.

So what is the typical timeline for a IPO?

First, you’ll hear about the S-1 filing. This is a initial registration statement that any company planning to go public has to make with the SEC. That’s the first formal indication that an IPO is coming, although often there will have been buzz about the possibility of an IPO for a while beforehand.

The period between the S-1 filing and the actual date of the IPO can vary, but is typically about 2-3 months. The IPO date is when the shares first trade publicly on an exchange. However, company insiders, including you as an employee, cannot start trading at this point as you’ll be subject to a lockup period.

The standard lockup period is 180 days, or about 6 months. Again, there are some exceptions to this, but 180 days is the most common length.

In total, that means you are likely to have about ~9 months from the date of the initial S-1 filing until you are actually able to sell any of your shares. Keep this time period in mind because your holding period is critical to the taxation of your stock sales.

Make sure you know exactly what you own

This seems obvious, but often can be more confusing than expected. Especially for employees who have been around the company for a long time, you might have multiple grants and a mix of equity types.

There are two common forms of startup equity compensation. One is stock options. These come in the form of incentive stock options (ISOs) and non-qualified stock options (NSOs), or you might have both. The second is restricted stock units (RSUs). Again, there can be variations.

We explain the tax implications of each below, but the first step is to make sure you know what you own, how much, and the relevant grant & vesting dates. All of this can be found in your stock grant documents, usually available online if your company utilizes a cap table manager like Carta or Shareworks/Solium. If you have trouble deciphering the documents, reach out to us at Visor for help.

Big tax break for those with Qualified Small Business Stock (QSBS)

A critical step after compiling what exactly you own, as outlined in the previous step, is determining whether any of your holdings qualify under Section 1202, which covers the rules for Qualified Small Business Stock (QSBS).

QSBS is an amazing tax break, but has some complications.

To qualify, you must have original issuance stock (e.g. not stock that you acquired in a secondary market) of a C-corporation engaging in ‘qualified businesses’, and the stock must have been acquired when the company had $50 million or less in assets. For most early stage startup employees, there’s a good chance that you can qualify. You’ll need documentation from your employer that helps justify your eligibility and you’ll want to work with an accounting firm like Visor that is familiar with the QSBS rules.

That’s because the benefit of QSBS tax treatment is that you can exclude up to $10 million in capital gains. For stock that was granted prior to September 28, 2010, there’s a chance there might be some tax impact from the Alternative Minimum Tax (AMT), but regardless this can be big tax savings.

If you think you qualify for QSBS, you’ll want to confirm. Then take that into account as you move through the remaining sections of this blog. QSBS can apply to both options and RSUs, so you’ll want to base your selling strategy around it.

What are the IPO tax implications for employer stock options?

ISO & NSO Tax Treatment

Remember, with stock options, there are two key decision points: 1) exercising the option, which is effectively buying the stock, and then 2) selling the stock. Your options come with a strike/exercise price (which stays constant), and when you exercise the option, you pay that price to buy the shares. You then make a profit on the options by being able to sell the shares at the current market price, which should be much higher after the IPO as compared to your initial strike price.

From a tax perspective, both these points are potentially taxable. When you exercise the option, we calculate your gain up to that point. This is measured by taking the current fair market value of the shares (aka the market price of the company’s stock on the date the option is exercised) and subtract out the original exercise price. This gain, even though it might only be paper gains if you haven’t yet sold the shares, is known as the bargain element.

Then, when you sell the shares, we look at the difference between the actual sale price and the fair market value from when you first exercised the options. If you exercise the options and then immediately sell the shares on the same day, there likely won’t be a gain/loss from this calculation. However, if you exercised the options a while before selling, possibly even several years prior, the subsequent gain amount could be significant. We refer to this gain as the capital gain.

The tax treatment of the bargain element and capital gain depends on whether you have ISOs or NSOs and the holding period between the grant date, exercise date, and sale dates. We summarized the tax treatments of the employer stock options below:

Bargain Element

ISOs: Taxable for AMT purposes only

NSOs: Taxable at ordinary income rates

Capital Gain

ISOs: Qualify for lower long-term capital gains rates if do not sell until at least 1 year after date of exercise and 2 years after original grant date (note that this will apply to the bargain element as well, and any AMT tax paid previously will be credited back)

NSOs: Qualify for lower lower long-term capital gains rates if do not sell until at least 1 year after date of exercise (note: only applies to capital gain as bargain element was already fully taxed at exercise)

Check out our guides if you need a deeper dive on the taxation of ISOs or NSOs.

Key Takeaways for ISOs & NSOs

The key decision you’ll need to make with your stock options is whether (and when) to exercise if you have not already. In some cases, your company will have a deadline date to exercise your options as part of the IPO process (often shortly following the lockup period), meaning your only choice is to whether you exercise immediately or wait until the last allowable day.

With NSOs, there will be a tax hit at exercise, so unless you think the stock price is likely to rise meaningfully between now and the IPO, you might decide to wait until after the lockup so that you can sell some of the stock at the same time to have funds to pay the taxes. However, there could be reason to spread out the exercise if possible so that part of the gain is recognized in one tax year and part in another, depending on your other income and which marginal tax bracket you will be in. So it’s still worth consulting a tax advisor.

ISOs can be even trickier. That’s because, to get the long-term capital gains treatment for the entire gain from strike price to final sale price, you need to have a one year period between exercising and selling (in addition to the two year hold period between grant and sale). However, the bargain element gain at exercise is taxable for AMT purposes. The new tax law raised the income thresholds on AMT so it doesn’t affect as many people anymore, but it still exists and certainly will come into play if exercising a meaningful amount of stock options. In this case, if you’re hoping to optimize the total taxes paid, then you will want to have a tax projection done to figure out your exact AMT implications. This will help you with cash management as you build an exercise and selling strategy. It’s important to get started ASAP if you haven’t yet exercised, since the sooner you do so and start the clock on your holding period, the sooner you’ll be able to sell after the one-year mark.

What are the IPO tax implications for restricted stock units (RSUs)?

RSU Tax Treatment

Restricted stock units for private companies tend to come in one of two forms: single trigger and double trigger. We’ll note though that these are not the technical term (there really isn’t a standard term to differentiate these two types of RSUs), so you have to figure out which type you have by reading your stock grant agreement, or getting some help (we’re here for you 😉 ).

Single trigger RSUs are taxable to you as they vest. What that means is you owe ordinary income taxes on the market value of the RSUs that you receive on each vesting date. The value would be determined by multiplying the number of shares by the 409a fair market value of the shares. Typically, a portion of your shares will be withheld by your employer to cover the taxes. They’ll buy those shares so that there is cash to then provide to the government. Any increase in the share price after vesting is a capital gain, and the long term capital gain treatment will be applied if the shares are held one year after vesting before being sold.

Double trigger RSUs are not taxable to you until they have both vested AND the company has IPO’d (hence the name ‘double trigger’). These were designed to avoid causing you a tax bill before the shares could even be sold for cash. The exact specifics can vary by company, but often they’ll become taxable at the IPO date, with the FMV based on the IPO price. You’ll pay ordinary income tax rates on this amount, and your employer generally will withhold a portion of the shares to cover the tax. Any gain (or loss) occurring from the IPO date to when you eventually sell after the lockup period will be a capital gain. If you hold for 12 months, the capital gain will be considered long-term and subject to the preferential rates.

Key Takeaways for RSUs

Generally speaking, RSUs are a bit simpler than options. But there is still tax planning to do, and mistakes that are far too common.

First, make sure you understand how much of your RSUs were withheld for tax purposes. This is not always a standard amount, and it can often be lower than what your actual tax bill will be. That means you could be surprised by a big tax bill in April to makeup the difference! For instance, we’ve seen withholding rates of 35%, when the employees actual tax rate might be closer to 45% after including both federal and state taxes – that 10% difference on a big chunk of RSUs could result in a big hit to the wallet come tax filing time.

Second, determine whether you have single trigger or double trigger RSUs, and thus when they become taxable to you. This is the date that the capital gain clock starts as well. Given that your shares likely vested over a period of time, often monthly over four years, not all your shares became taxable on the same day. What you want to know is which of your RSUs will have passed the one year mark from vesting by the time the lockup expires – since those shares are eligible for long term capital gains on any stock price appreciation since that vesting date. If only selling a portion of your shares, you might want to purposely sell those shares rather than the ones you’ve only had for under 12 months. But all of this needs to be evaluated in context of your financial goals and individual tax circumstances!

Tax considerations of charitable giving

If you are feeling charitable, there can be tax benefits to donating away some of your shares. There are special rules though that apply to employer equity compensation, such as RSUs, ISOs, and NSOs, that make this process slightly different than when you donate other stock holdings from your brokerage account.

Donating your employer stock can be very beneficial if done correctly. You get a double benefit: 1) an itemized deduction on your tax return equal to the market value of the stock, and 2) the avoidance of recognizing the capital gain and paying all those taxes.

Each stock type has specific rules around them though that you’ll need to be sure to follow. For instance, often NSOs are not allowed to be transferred, so you’d likely have to exercise them first and donate the stock. Since there are tax implications to exercising, the benefits to donating the stock might not be as big as anticipated. For ISOs, holding period rules come into play since, if you donate the shares within one year of exercising, then it no longer counts as a qualifying disposition. Bottom line: talk to a tax expert familiar with employer stock before making the donation.

If you do want to give a portion away to charity, a Donor Advised Fund might be the best vehicle. This is because you can often get all the same tax benefits but you don’t yet have to actually direct the money to a particular charity. The funds get invested first, and you can donate the money over time. It’s a favorite of a lot of our clients, and setting one up is relatively easy as can often be accomplished via a simple phone call to your brokerage firm.

Next Steps

If you don’t yet have a plan, it’s time to get on it. Whether your company already IPO’d, is about to IPO, or is still a couple years away, consult a Visor tax advisor to optimize the after-tax returns on your shares.

2 Comments

Thanks for the article!

Let’s say you hold NSOs in a company that goes public and you wait until the end of the lockup period to exercise. Is there typically a way to do a cashless transaction where you exercise the options and sell the shares at the same time? Or do you need to somehow come up with the cash to exercise before you can sell?

Glad you enjoyed it! Great question. Yes, typically if waiting until after the lockup period, there is the ability to do a cashless transaction as you described. However, that’s dependent on your employer and the broker where you stock is held, but typically it is possible to do a cashless exercise since you place the sell order simultaneously.